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Real Earnings Management and Subsequent Stock Returns

Real earnings management (REM) practices are related to subsequent stock returns. Specifically, stocks of firms with abnormally low (high) levels of operating cash flows underperform (outperform) in the subsequent year, whereas stocks of firms with abnormally low (high) levels of production costs outperform (underperform) in the subsequent three years. This relation is stronger among firms with greater likelihood of earnings management and does not exist for the normal levels of operating cash flows and production costs. Quintile spread portfolios based on either REM measures yield factor-adjusted annual abnormal returns of about 6%, with more than 40% of which being realized over the subsequent four earnings announcements. Further tests show that the return predicting power of the REM measures is likely due to mispricing rather than systematic risks.